Financial Exposures and Risks in Business

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Introduction

Exposure is a defined as a measure of the change in the value of a financial item such as a liability, asset or cash flow, to changes in the relevant risk factors. On the other hand risk is defined as a measure of variations in the item’s value in relation to the risk factor (BOJ, 1996, p. 2). The company’s exposure and risk is defined as a function of volatility and impact. It also defines how volatile the item in question is and the financial impact of that volatility. The company’s organization level of risk aversion or appetite determines whether the exposure is acceptable or not (BOJ, 1996, p. 5).

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Treasurers play as great role in the management of risks at different levels of any given company. Some of the financial risks dealt with include liquidity risk, risk to cash, equity risk, commodity risk, interest rate risk sand foreign exchange risk. Additionally, a treasurer has the duty of identifying and managing exposures as well as cash. These exposures include transactional, economic and translational exposures (Buckley 2004).

Transactional exposures

When a firm engages in transactions in which foreign exchange currency is used, there are risks associated with gains or losses, known as transactional risk. Transaction exposures arise due to unexpected adverse changes in prices. For example, a US based company buying goods from a Japanese company will incur transaction risk because it is exposed to the exchange rate fluctuation.

According to Lam (2003), transactional exposures are common where transactions are conducted on credit; cross-border transactions; foreign exchange contracts; and international acquisitions.

Transaction exposure for MNCs can be managed through internal and external techniques. Internal Methods of exposure management include netting, matching, leading and lagging balance and determining currency of invoice, pricing policy, asset liability management. On the other hand, external techniques of exposure management include forward market hedge, short-term borrowing, currency overdrafts, discounting foreign currency-denominated bills of exchange, counterparty risk, exchange risk guarantees and factoring foreign-currency-denominated receivables.

Managing transactional exposure through Currency Swap is whereby the companies involved in the transactions agree to exchange specified currencies without varying the exchange rate, such as companies limited by foreign exchange restrictions and forward contracts. The rates agreed upon are computed to show the variations in the interest rate (Interest rate parity).

Netting, on the other hand involves the use of opposite exposures to mitigate the level of risk facing a company. Here the company can create one transaction exposure in order to offset (Embrechts 2000).

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Mathematically, transaction exposure (TE) calculates the value in domain currency of a specific transaction denominated in the foreign currency. As such TE can be measured, and an analysis of sensitivity of TE to changes in St, computed. From a simulation or a statistical distribution, if the results show less sensitivity of TE to St, least attention should be paid to changes in St.

The two common measures for Net TE include, measure for single transactions and measure for all transaction (portfolio approach); the latter incorporating correlations. Given two random variables X and Y, the correlation between them is given as:

Corr(X,Y) = ρXY = σXY/(σYσY),

Whereby, the MNC while calculating the NTE considers the correlation of the major currencies. For example, a US MNC with two subsidiaries, one in Europe and the other in UK, records Subsidiary A has a cash flows in Euro (CF(in EUR)>0) and subsidiary B in pounds CF(in GBP)<0; implies that the correlation coefficient (ρGBP,EUR) is very high and positive. For this MNC, the Net TE might be very low. Therefore, the hedging decisions were not made based on transaction, but on the basis of exposure of the portfolio.

Example

As a MNC, Swiss Cruises has a Net TE in US dollars worth 1 million due for payment in Canadian dollars (1.5 million) in 30 days, the St = 1.47 CAD/USD, and a correlation coefficient (ρCAD,USD) of 0.924 (1990-2001). The MNC views the Net TE to be close to zero. Due to great variations in correlations across currencies, there is high correlation across regional currencies. The pound and the Euro correlated at an average of 0.71, while the pound and MXN averaged at -.01, from 2000 to 2007. The chart below show the 4-year correlation values of the GBP versus the USD and the MXN versus the USD.

The chart of the 4-year correlation values of the GBP versus the USD and the MXN versus the USD

In order to conduct a sensitivity analysis for the portfolio approach, a simulation will consider the existence of different scenarios.

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Example

Nike reports the following cash flows in the next 90 days

Outflows Inflows St Net inflows
GBP 100,000 25,000 1.60 USD/GBP (75,000)
EUR 80,000 200,000 1.05 USD/EUR 120,000

The NTE (in US dollars) = EUR120,000*1.05USD/EUR + (GBP75,000)*1.60USD/GBP

= USD6,000, becomes the baseline case

Case 1: considering ρGBP,EUR = 1, that is a high correlation between the EUR and GBP, and in situation (a): the EUR increases by 10% to the USD.

Given ρGBP,EUR = 1, St = 1.05USD/EUR*(1+0.10) = 1.6 USD/EUR, and

St = 1.60USD/GBP*(1+0.10) = 1.76 USD/GBP

Thus, NTE (in US dollars) = EUR120,000*1.55USD/EUR+(GBP75,000)*1.76USD/GBP

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= USD 6,600, shows a 10% change

Situation (b): the EUR decreases by 10% against the USD

With ρGBP,EUR = 1, St = 1.05USD/EUR*(1-0.10) = 0.945 USD/EUR, and

St = 1.60USD/GBP*(1-0.10) = 1.44 USD/GBP

Hence, NTE (in US dollars) = EUR120,000*1.16USD/EUR+(GBP75,000)*1.76USD/GBP

= USD 5,400, shows a -10% change

Therefore, the NTE range is NTE Є{ USD 5,400, USD 6,600}

From the calculations, the resulting increases and decreases in NTE equals the change in St, and thus if a MNC has similar inflows in different denominations, the variations in St will not affect NTE.

On the contrary, in a case where ρGBP,EUR = -1 and the above twos situations prevail, a 10% change in St results to a huge increase in NTE range. Thus, a MNC with non-matching exposures in different denominations, and negative correlation is dangerously placed.

Instead, Nike will pick a correlation from the data, and fit it in a series of situations, to result in an empirical distribution for the NTE. The distribution will place Nike’s range and VAR at negative for NTE.

Economic exposures

Secondly, economic exposure (operating exposure) is the risk associated with unexpected changes in exchange rates, and local regulations within the business environment. This exposure may favor the services or products of a competitor and act to the disadvantage of the company’s long-term economic model. For example, the company’s long-term pricing strategy would be affected by devaluation of foreign currency, hence causing the product to be comparably expensive. In the foreign country therefore, the product would be less competitive eventually decreasing sales and profitability (Kupiec, Nickerson and Golding 2001).

Unlike other forms of exposures, economic exposures can be quantified through a number of measures, including Pro Forma, Regression/Historical, and Simulation/Future Approach.

For example, a regression model by a MNC on the dollar value (P) of its assets in UK on the exchange rate of the dollar against the pound ($/£), its regression model would be in the form; P = a + b + S + e,

Whereby a, is the regression constant; b, measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S; and e, is the random error term with mean zero.

Pro forma measure conducts an evaluation on the change in each line of the cash flow statement to a change in the exchange rates. This method assumes that only the exchange rate change for that particular year affects the exposure.

Using Regression/Historical Analysis one assumes that the future exposures will be like the past, once an initial evaluation has been conducted, the figures will be used in other analyses.

Lastly, the Simulation/Future Approach, is where no assumptions are made about the past, and instead the analyzer must know how factors will affect the cash flow to get the best results of a Monte Carlo analysis.

To get the best results during the analysis of economic exposures, a combination of the three methods is recommended. The analysis using the three methods will serve to limit on the shortcomings of each method. Although there is no perfect way for a company to manage economic exposure, a number of actions that can be taken to reduce the impact of this kind of exposure include production management, marketing management and financial management.

Production Management can be conducted through Product sourcing or shifting production. The company can diversify its sources of raw materials, by adopting product outsourcing. For instance sourcing materials from a country with a weaker currency, the production country is shielded against losses associated with devaluation because some of the costs of sourcing the materials had been offset by the low cost in the weaker currency country. On the contrary, shifting production is when currencies in the country of production become expensive; the Company can shift to countries with weaker currencies with lower costs so as to improve its profit margins.

Similarly, Marketing Management is applicable through geographic diversification, market segmentation, market share versus profit margin and product differentiation.

Through marketing management, if the company is working in different countries, it’s positioned to balance their profits. Weakened sales in one country will be countered by an increase in another, because of change in currency values.

Segmentation of markets allows the company to produce goods and services that can be in both extremes (both luxurious and economy) of the market segments. Market share versus profit margin determines the association between the company’s share of the market and the return. A higher market share will imply that the company is enjoying huge profits, and vice versa. Product differentiation allows the company to produce different products which helps in reducing product sensitivity to price changes. Finally, in financial management the company should arrange for alternative financing so that in case of a decrease in sales from a weaker currency will be compensated by cheaper debt servicing costs.

Translational exposures

Multinational corporations with subsidiaries in other countries when consolidating their financial statements for their stakeholders, deal with translation exposure during the conversion of assets and liabilities into the currency of the parent company. During the conversion process gains and losses result from foreign currency fluctuations. This exposure of adverse effects in a firm’s reported financial statements is also referred to as an accounting exposure (Quinn 2005).

Financial Risks

There are many risks in the running of a company and each sector deals with different risks. The treasurer plays an integral part of the company’s risk management framework. The various types of financial risks include Liquidity risk, Commodity risk, Foreign exchange risk, Market risk and Credit risk (Telegro 1998).

Primarily credit risk affects members to a contract, when one party fails to adhere to the terms of the contract, by either failing to pay, or deliver the contract. Credit risk can therefore be managed by using derivatives or credit analysis techniques to protect the parties to the agreement.

Secondly, liquidity risk is the lack of the required resources to purchase or dispose of an asset. During the investor’s time limit, there is the likelihood that the security’s liquidity will be altered, such that a decline in the assets liquidity will adversely affect the client’s expectations.

Thirdly, Commodity risk focuses on the uncertainties in the prices and the availability of the commodities in the current and future markets. It can be broken down into Market risk, operational risk and credit risk (Embrechts 2000)

Fourth, Foreign exchange risk is the exposure of an institution to the potential impact of movements in foreign exchange rates. It arises from two factors: currency mismatches in an institution’s assets and liabilities and currency cash flow mismatches, consequently affecting the company’s net cash flows and profitability. Management of foreign exchange rate risk can occur through options, forward contracts, and money market transactions (BOJ, 1996).

Fifth, Market risk is the uncertainty related to the change in value or liquidity of a portfolio of financial instruments resulting from changes in the financial markets.

Risk management

In order to create conducive environment for operation, companies opt to manage the risks through such methods as acceptance, management, or transfer. Acceptance of risk curtails the efforts of finding ways of mitigating such as absorbing the volatility through earnings with the assumption that the events upside will outweigh the downside.

Instead of accepting, a company may decide to manage the risk through a hedging program with the aim of mitigating risk as opposed to eliminating it. Mitigation of the risk can be through an option, a swap or an offsetting asset or liability that limits the uncertainties of the impact to value or cash flow (Jarrow and Turnbull 2000).

Hedging is used to reduce volatility by reducing the variance in possible outcomes. By doing so, the hedging company is also used to reducing financial distresses by narrowing the distribution of probable outcomes thus lowering the probability of financial stress.

Alternatively, instead of managing risk through acceptance, a company can pass the risk to a different party e.g. the customer or back to the supply chain through increased prices or a surcharge. It is hard in high competitive price environments especially if the company is a price taker in the market. Passing the risk to vendors and other customers will only transfer the cost of the risk (White 2004).

The performance of a firm depending on profitability can be affected by foreign exchange exposure. Therefore, it is important for firms to ensure effective measurement and management of foreign exchange exposures and risks, through such methods as hedging risk, forward contracts, swaps and un-hedged positions.

Primarily, Simons (1999) believes that hedging risk involves reducing the level of exposure to foreign exchange risk likely to face a company because of changes in the exchange rates. This position taken by most managers, reduces the risk they otherwise would have faced, and instead shield them from major losses and challenges on investments, by lowering the variation expected on the cash flows.

Similarly, forward contracts as a hedge against exposure to foreign exchange risk is a contract between two parties stipulating the terms of the agreement as making a transaction, at a specified future date, at an agreed exchange rate (Jorion 2001). Below is an example of a forward market hedge:

A U.S. importer trading in British woolens has just ordered inventory for the following year. The payment to be made in a year’s time totals to £100 million. Option 1, is for the importer to take a position that delivers £100 million in a year’s time, that is take a long forward contract on the sterling pound. In this case the importer will hedge his £100 million to be paid with a money market hedge, by borrowing $112.05 million in the United States. Then convert the $112.05 million using a spot rate of S($/£) = $1.25/£ into £89.64 million, $112.05 = {£89.64*($1.00/£1.25)}

At a rate of return i£ = 11.56%, the U.S. importer will invest the £89.64 million in UK for one year. The investment, after one year will have grown to £100 million, given by (£100/1.1156) = £89.64

Third, currency options contracts in managing a company’s risk profile, gives the owner the right and choice to either purchase or sell at an agreed price for the duration of the contact. Unlike forward contracts, the flexibility associated with options leaves room for the owner to either decide to exercise or not, depending how profitable the transaction seems.

Lastly, the use of un-hedged positions means that certain managers decide not to protect themselves against foreign exchange risk. Their decision is based on the premise that currency risk management instead of positively contributing to the company’s cash flow, reduces variability and consumes reduces.

Conclusion

Measurement and management of risk and exposure depends on their level of risk aversion. Examples of risks and exposures that treasurers seek to measure and manage include liquidity, equity, commodity, interest rate and foreign exchange risks; and transactional, economic and translational exposures. Due to the international nature of the business transactions of MNCs, various methods are available for measuring, managing and mitigating the risks. Therefore, in order to be effective, treasurers must combine a series of methods, especially for the exposures.

Recommendation

Although MNCs attempt to measure and manage risk and exposure while in the international arena, rarely do the majority effectively profit from the strategy. Treasurers employ diverse methods in this quest, but the above analysis points to the need for organizations to combine a number of strategies to be effective. Similarly, the unexpected changes in the foreign exchange rate across country borders greatly determine the impact of foreign exchange transactions to the company’s profitability. Hence, coordination among an organization’s functional departments will aid in the effective and efficient measurement and management of risks and exposures.

References

Bank of Jamaica (BOJ) 1996, Foreign exchange risk management: standard of sound business practices, pp. 2-15. Web.

Buckley, A 2004, Multinational Finance, Prentice Hall, New Defhi.

Embrechts, P. (ed.), 2000, Extremes and Integrated Risk Management, London: Risk Books.

Jarrow, Robert A. and Stuart M. Turnbull, 2000, “The Intersection of Market and Credit Risk”, Journal of Banking & Finance, vol. 24, no. 1/2, 271-299.

Jorion, P., 2001, Value at Risk: The Benchmark for Managing Financial Risk 2nd Edition, New York: McGraw Hill.

Kupiec, P., D. Nickerson and E. Golding, 2001, “Assessing Systemic Risk Exposure Under Alternative Approaches for Capital Adaequacy,” presented at the Bank of England Conference, Banks and Systemic Risk, 2001.

Lam, J 2003, Enterprise Risk Management: From Incentives to Controls. Hoboken, NJ: John Wiley.

Quinn, LR 2005. “ERM: Embracing a Total Risk Model.” Financial Executive.

Simons, R 1999, “How Risky Is Your Company?” Harvard Business Review, 85.

Telegro, DJ 1998. “A Growing Role: Environmental Risk Management in 1998.” Risk Management, 19.

White, L 2004, “Management Accountants and Enterprise Risk Management.” Strategic Finance.

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